Monthly Archives: March 2018

For the first quarter of 2018, my portfolio declined by 3.46%, and the S&P 500 dropped by 1.22%. My strategy still isn’t delivering any outperformance from when I started. I’ve discussed the reasons on this blog. I think a bulk of it is due to value investing’s underperformance as a strategy and specific errors that I’ve made with stock selection.

I believe the outperformance will come, but there is no way to tell when it will happen. It’s not something that you can time. I just have to stick to it and be patient.

Sentiment Shift

With that said, it feels like the sentiment is starting to shift in a way that might benefit value stocks.

For years now, the market has been rewarding cool, growth-oriented companies with higher and higher valuations. You know their names: Facebook, Apple (although Apple is odd in that it sometimes trades at a dirt cheap valuation), Amazon, Google, Netflix, Tesla, Nvidia. I would even lump cryptocurrency’s run into this bucket as an example of the sentiment.

Cool things rarely reward investors. Nearly all growth companies eventually run into problems that investors can’t anticipate or imagine. The higher their valuations (i.e., the higher the expectations), the harder they do fall once they run into the problem, which is inevitable. It appears that the stars of this bull market are simultaneously hitting those problems.

Tesla, for example, has been a star of this bull market. Its rise is due to a cool product and a popular CEO. The rapid rise in Tesla stock to absurd valuations gave Elon the currency to issue new shares and debt to keep the company afloat. Meanwhile, the company has never been profitable or generated significant cash flow. That sentiment appears to be shifting.

A friend of mine owned a Tesla and took me out for a ride in it once. It’s an impressive vehicle. The iPad instead of a console, the quick and silent acceleration. All of it is super cool. With that said, auto innovation is quickly commoditized. Think about it: your bottom of the line economy car (think about a Nissan Versa or a Toyota Yaris) has all of the features that a luxury car had in the ’90s. I’ve never been a “car guy.” For me, every car does 80 mph (which is all you can get away with on a highway) and has all the features I need. Why spend any more money than I need to? Tesla’s innovations are fresh and exciting, but in 10-20 years it’s just going to be standard. The big automakers are going to copy and compete away Tesla’s innovations. In the long run, it’s probably road kill. In the short run, the stock is at absurd valuations.

Facebook Is Bad For You

Facebook is running into problems as well. The problem which has been brewing for years is privacy concerns. Facebook presents its business model as a benevolent force aimed at “connecting humanity.” The reality is that it is an addictive product whose goal is to get people to turn over information about their lives, which Facebook then sells to advertisers. The perils of that business model came to a turning point in the recent scandal with Cambridge Analytica. I don’t know if the scandal will disrupt Facebook’s business model. As long as people continue to upload their life’s details to the site voluntarily, Facebook will have something that they can monetize. With that said, recent events do appear to be having an impact:

I dropped my Facebook account a couple of years ago. Privacy was a part of it, but for the most part, I felt like Facebook was bad for me.

For me, I felt like Facebook was rotting my brain. That was the cost I was paying. The benefit was the connection with friends and family, but even that was entirely superficial. I also found myself wasting a lot of time on the app.

Regarding “brain rot,” a lot of it had to do with politics. The odd political opinions of my relatives and friends were making me dislike them. I thought to myself: did I become friends with these people because I agreed with their politics? Should a family member’s weird political opinions make me love them any less? The answer was, naturally, no.

Moreover, the bizarre beliefs I read on Facebook were hyperbole. The hyperbole on Facebook pollutes people’s outlook on the world. I also had to admit; the same thing was happening to me. I was confining myself to a shrinking bubble of information, and the increasing intensity of it all was polluting my mind. I found myself emotionally reacting to political posts instead of thinking critically about them.

The other odd thing I noticed was increased envy and jealousy. It’s unconscious, but it happens. No one posts their real life on Facebook. No one goes on Facebook and says “I had a huge fight with my husband today and I think he’s a jerk.” No one goes on Facebook and says “My children have so poorly behaved today that it makes me feel like I’m a bad parent.” No one goes on Facebook and says “My career feels like it hit a dead end and it makes me question my life choices.” However, these examples are all natural feelings that most people go through.

When you only see people post mostly “good” things about their lives, you start to think that your own life is inadequate, even though their life is probably as challenging and screwed up as your own. Think about it. Is life the happy pictures – the wedding albums, the graduation pictures, smiling families at events (the stuff that people put on Facebook) – or is it more nuanced than that? Every life has pain and disappointment. That’s not a bad thing – it’s just life.

People aren’t sharing their problems publicly on Facebook, but problems are still happening. We’re all human, and we all have issues. Social media makes us forget that and makes us feel inadequate.

I think more people are going to realize what I realized a couple of years ago. Facebook rots your brain and kills your self-esteem.

One of the most significant challenges in life is preventing your emotions from fooling you. Social media can make that an even more difficult task than it already is.

I digress. For growth stocks, the sentiment does appear to be shifting. We’ll see if it lasts.

Macro

The average investor allocation to equities

At the end of last year, the average investor allocation to equities in the United States was 43.787%. We are now beyond previous sentiment peaks, and current valuations had only been higher in 1998-2000. The 43.787% metric implies that in the next ten years we can expect returns of roughly 2.5%. The 10-year treasury yields 2.74%, so stocks no longer offer a premium over bonds.

The road to those returns is unknowable, but I think most investors are going to be disappointed in their returns over the next decade.

The spread between the 10 year and 2-year treasury. When the 2 year has a higher yield than the 10 year (an inversion), it implies that monetary policy is too tight and will probably trigger a recession.

Concerning recession risk, the yield curve has not yet inverted, but it is in the process of flattening as the Fed raises rates. The lack of inversion means that a recession is unlikely over the next year. Eventually, however, the Fed’s tightening will cause a recession as it always does. The Fed is the cause and cure of every recession.

What this means for the short-term direction of equities is anyone’s guess. It does reduce the risk that equities will go down in a 2008-2009 style 50% drawdown. If the market does decline, it will probably be more like the 2000 decline. The economy was healthy, but valuations were absurd.

Of course, this bull run might just be getting started, and valuations may get even more insane. Over the short run, it is unpredictable, but we can infer from valuations that long-term returns will not meet investor’s expectations.

The Return of Volatility

After remaining dormant for a long time, volatility returned in force back in February. Volatility spiked, the market went down a little bit (10%), and everyone lost their minds. For people who were crazy enough to “short” volatility, they suffered a permanent loss of capital.

What’s funny about the whole ordeal was that the market decline was pretty tame and the rise in volatility was actually pretty normal in a historical context:

The return of volatility: angels and ministers of grace defend us

It was also really funny to me that so many tried to develop an explanation for the February decline. The reality is that there still isn’t agreement on what caused the crash of 1987! If we can’t fully understand what caused the crash of 1987, how can anyone say with authority what caused a 10% hiccup in February?

Everyone overreacted and lost their minds over a pretty normal event.

Volatility is your friend. Volatility is Mr. Market overreacting to events and losing his mind. You want to take advantage of Mr. Market, not be ruled by his mood swings. Too many investors fail to understand that the volatile nature of stocks is the reason that they offer opportunities to purchase mispriced assets.

If you can’t handle volatility – if you can’t handle very normal events like the one in February – then you don’t belong in the stock market. Bottom line, if you can’t afford to lose half of the money invested, it shouldn’t be in stocks.

Stocks are going to suffer a massive decline at some point. You can’t predict when that will happen, but I guarantee that in the next 10 years there will be multiple episodes when stocks suffer gut-wrenching declines. If you can’t handle them, then stay the hell away from the market.

It’s a good thing that most people can’t handle volatility and have no stomach for the gut punch that stocks frequently deliver. As long as most people are like this, Mr. Market will continue to offer attractive opportunities to people with the right emotional temperament.

My Portfolio

Below is a list of all of my open positions and the percentage change since I bought them:

Random musings:

Retail: My retail stocks continue to weigh on my portfolio with the notable exceptions of Dick’s Sporting Goods and Foot Locker. Both companies delivered somewhat decent news, which was enough to deliver some solid gains. The two cheapest stocks in my portfolio (Francesca’s and Gamestop) continue to disappoint. Big Five isn’t doing quite as bad as those two, but it is still making me wince. Amusingly, Francesca and Gamestop are the two stocks that I am the most excited about. They are both priced for roadkill and any whiff of good news is going to send the stocks soaring (I hope).

The international index ETFs I purchased for countries with low CAPE ratios are all doing very well and delivering solid performance. Russia and Singapore are doing the best, while Poland is the only one that is down.

I didn’t do much this quarter. I did one trade, a small purchase in Argan. I had $1,000 in cash left from a distribution from Pendrell (odd lots were paid out when the company de-listed) along with some dividend payments. I decided to deploy it in Argan, which is an absurdly cheap stock with an enterprise value that is less than 1x its operating income. The timing was lucky, as the stock surged almost immediately after I bought it.

Aflac was fairly volatile this quarter due to some lawsuits from former employees. The stock had a brief decline and then bounced back. It doesn’t seem to be a big deal and the stock continues to be one of the cheapest in the S&P 500.

Before you invest your hard earned money, put the company under the microscope.

I received a request from a reader on how to read financial statements and do some basic company research. I thought it was an excellent idea for a post!

Below is a very brief summary of places and methods to find information on companies along with a description of how to read financial statements.

Accounting statements aren’t something that generates “clicks,” which is why some of these basics are hard to come by on a basic google search. I wish I had a little summary like this when I started out.

Types of Financial Statements

I throw around terms on this blog like “enterprise value,” “net current asset value” like everyone knows what they are. Of course, not everyone does, so I hope this helps.

As a brief recap of Accounting 101, here are the three financial statements and their purpose:

Balance sheet – The balance sheet is a statement of a company’s assets and liabilities at a fixed point in time.

Income statement – This is a snapshot of how much money a company made over a period of time.

Cash flow statement – This is a breakdown of how a company’s cash position changed over a period of time. The statement of cash flows wasn’t required for a company to post until the 1970s.

Where to obtain financial statements

Google Finance was my go-to source for financial statements. It had a very nice summary of financial statements, with accompanying charts. For some reason, they decided to dump it. Their “financials” section is currently a few critical ratios on the company.

These days, there are a few places you can obtain free financial statements. Morningstar is an excellent source and offers free financial statements and valuation ratios. They also show relative valuations, which is nice when you want to compare a company to others in the same industry. Just go to the website, type in the ticker, and go to financials.

Yahoo Finance is also an excellent alternative to Google Finance. In their “statistics” section they even break down EBITDA and Enterprise Value, which is something that Google never did. On the downside, the website isn’t as clean and fast as Google used to be.

Why, Google, why?

K’s and Q’s

The gold source for financial statements is company filings with the SEC. When I am interested in a company, I usually start my search with free services like Yahoo. If I like the numbers, I will then go to the SEC website and delve deeper.

Because it’s possible that the free service (Yahoo, Google, Morningstar, etc.) may have input the wrong #’s into their online financial statements, I always double check their work by going straight to the 10-K and make sure that the numbers match up.

You can find 10-K’s for free at the SEC website. Scroll down on the homepage and search any ticker:

The output of this search looks exceptionally intimidating.

Don’t be intimidated. The documents you want to focus on are the K’s and Q’s. 10-Q’s are quarterly statements. 10-K’s are annual reports.

When you click on a K or Q, you’ll receive another batch of documents. The only doc you need is the first one. That will contain the financial statements and management commentary.

The 10-Q will start off with the consolidated financial statements. This is the financial statement for the entire company. If you scroll down in the 10-Q, it will break out separate financial statements for each division along with commentary. For our purposes, you only need to concentrate on the first financial statements that you see, the consolidated financial statements.

My recommendation is that you check out the consolidated statements on the free sites. If you like what you see, double check Yahoo and Morningstar’s work by going to sec.gov and double checking the numbers for yourself.

Typically, my focus on the 10-Q is the financial statements.

Once I’ve checked the numbers, and I like what I see, the next step is reading the 10-K. I recommend reading the recent 10-K for every stock that you buy. The 10-K will provide financial information, but it will also summarize all of the company’s activities more robustly than you’ll find on the quarterly statements.

In my opinion, the most critical section of a 10-K is called “risk factors,” and it is generally near the beginning of the report. This is the section where management is legally required to disclose anything that they deem to be a risk to the business. In other words: while much of the 10-K is management’s opportunity to gloss over and obscure problems facing the company (it’s like a job interview – they are going to give you 110% and their only weakness is that they work too damn hard), the risk factor section is one where they are legally required to cut through the B.S. and tell you what they’re worried about.

The SEC: A watchdog and fountain of information

The SEC is one of the main reasons that I only buy individual stocks in the United States. The SEC isn’t the perfect watchdog, but it’s the best in the world. With the SEC website, you have every public company’s financial statements at your fingertips. Moreover, you have an enforcement agency to keep these companies honest. I’m fine with buying a massive basket of 50 companies in one country, but I simply don’t trust other enforcement agencies enough to buy individual foreign stocks. I also can’t easily find financial statements the way that I can in the U.S. As a guy with a full-time job for whom investing is a hobby, I also don’t have the time to dig around to find foreign financial statements. Reading everything available for a US companies takes up enough time!

The Balance Sheet

As stated earlier, the balance sheet is a statement of a company’s financial position at a given point in time. The focus here is on assets and liabilities.

The balance sheet is broken up into three sections: assets, liabilities, equity. Equity is a confusing term in finance because it is used to describe different things. Equity can mean an ownership interest in a company. On a balance sheet, equity is merely the difference between assets and liabilities.

The balance sheet equation is simple: Assets – Liabilities = Equity

When we talk about book value, we’re talking about equity. That’s the accounting asset value of the entire company.

Assets

Assets are broken out into current assets and long-term assets. The order of items begins with the most liquid and liquidity decreases as you go down the list of assets. Current assets are assets that can be liquidated in a time period less than a year, so they are listed at the top. The most obvious asset is at the top: cash and cash equivalents.

The second section is longer-term assets. Property, plant, and equipment is pretty basic. That’s the big stuff that the company owns. Buildings, smokestacks, etc.

Goodwill is a kind of accounting fiction. When a company acquires another company, they usually pay more than the true accounting value of the new company’s assets. They’re buying the company for its long-term cash generating ability, not merely the value of the stuff that it owns. This excess amount is treated as an “asset” and is on the books as goodwill.

Goodwill also comes into play on the income statement. Goodwill is expensed over time, an event that is called “amortization of goodwill”. This is why income estimates like free cash flow or “Earnings Before Interest, Taxes, Depreciation, and Amortization” are designed to exclude items like this. It’s not a direct cash expense.

Deferred taxes are assets that the company expects to recoup at a later date in the form of a tax refund. This is not liquid because the company can’t just sell this or obtain it immediately. They have to wait until the appropriate time to include this expense.

When we calculate tangible book value we are stripping away goodwill and intangible assets. In contrast, book value treats all assets equally. Tangible book value focuses on assets that you can actually turn into cash. Tangible book value = Tangible Assets – Total liabilities.

Ben Graham’s Balance Sheet Approach

Ben Graham’s focus was on net current asset value, which is even more conservative than tangible book value. Ben didn’t even give value to property, plant, and equipment or longer term assets. His goal was to focus on what the company could sell for as scrap. He thought that asset value should focus entirely on current assets. Net current asset value = Current Assets – Total Liabilities.

When Ben took the metric to an even more conservative extent, he focused on working capital, which was the current asset value which only assigned 75% of value to receivables and 50% of value to inventory. The idea was to get a rough approximation of a conservative liquidation valuation. In a liquidation, inventory would be unloaded at fire-sale prices and not all of our customers would pay the company back due to impending doom. This is the most conservative estimate of a company’s value. Company’s that sell below this value are essentially worth more dead than alive.

It was net current asset value and net working capital stocks that Ben Graham used to generate 20% returns for his investors in the 1930s through the 1950s. Warren Buffett used this method in the 1950s, but abandoned it because he became too large to employ it effectively.

Today, these opportunities mostly exist abroad. They are available infrequently in extreme situations (one stock I own is a net-net – Pendrell) during normal times. They are only available in large numbers in the United States during times of economic stress. Even then, they are in a micro-cap universe that most investors can’t take advantage of (this is a good thing!) They were available in large quantities during the dot-com crash in the early 2000s and after the 2008 crash. Like cicadas, they only emerge once every decade or so.

Like the assets section, the liabilities section is listed in order of the time in which the payments are due. Current liabilities are debts that the company needs to pay in a year. Accounts payable are short-term bills due. Further down the liabilities section is long-term debt, which are long-term items like bank loans and mortgages on properties.

Deferred income taxes, in contrast to deferred taxes in the assets section, are income taxes that the company will owe in the future.

When we talk about the debt to equity ratio, we are talking about long-term debt divided by equity. This is an excellent rough metric to measure how leveraged the company is. Current liabilities aren’t included in this metric because current liabilities may be a simple part of the business’s operation and aren’t a long-term risk. Graham recommended a debt/equity ratio below 100%. In my backtesting, I’ve found that debt/equity ratios below 50% tend to work best.

Enterprise Value

Enterprise Value is a term that value investors throw around a lot. Traditionally, investors focused on the total market value of a company’s stock (per share price times the number of shares) – also known as “market capitalization.”

Enterprise value goes beyond simple market cap and tries to calculate the total cost of the entire business to an acquirer. If we were to buy the whole company, we wouldn’t merely have to pay the market price. We would also become responsible for all of the company’s debts. We would also have to pay out holders of preferred equity. Additionally, we would have full access to the company’s cash on hand for whatever we want. The enterprise value is the sum of all of these components to arrive at the true cost of buying the company.

This is important because a company can have a low market capitalization, but a massive amount of other liabilities. Valuation ratios using the enterprise value try to take the entirety of a company’s size into the valuation equation.

You can calculate enterprise value by using the relevant balance sheet items and then adding it to the market capitalization.

The statement of income attempts to sum up how much money the company made over a set period of time.

As a general rule, the items at the top of the income statement are more reliable than the items at the bottom. It’s hard to fake sales, for instance. It’s easy to play games with taxes and depreciation. A typical income statement looks like the below:

The income statement is reasonably self-explanatory. You start with sales and you take away the cost of sales (also called “cost of goods sold”, or expenses directly tied into what you’re selling) and you arrive at gross profit. After gross profit, you take away “selling expenses” (all of your expenses that aren’t directly tied to what you’re selling).

If we were running a lemonade stand, sales are the total amount of money that we received from patrons for lemonade. Cost of sales would be cups, lemons, water, and sugar. Selling and administrative expenses are what we’re paying our lemonade stand employees.

You then take out depreciation and amortization. The full cost of an asset (i.e., our pitchers for the lemonade and wood to make the lemonade stand) isn’t expensed up front, it’s spread out over a period of time. For each period, this is the cost in the form of depreciation. Amortization usually refers to the “amortization of goodwill,” which is expensing how much we paid up for the business over its accounting value.

This then takes us down to “operating income”. When we’re talking about “earnings before interest and taxes“, this is what we’re talking about. The reason that many value investors focus on this metric of income is simple: (1) The further you move up the income statement, the less likely the numbers are to be manipulated, so it’s better to focus on an item closer to the top of the income statement. (2) If we’re using enterprise value in the denominator of the valuation ratio, we are already assuming that we’re paying off all of the company’s debts. This allows us to take away the interest expenses. In other words, it provides us with a rough-and-dirty way to compare the relative valuation of companies that have entirely different capital structures.

We then take out taxes, include money made from interest, and take out money spent on interest — this then brings us to net income.

From net income, to arrive at earnings per share, we subtract dividends paid to investors and other distributions. We then have “earnings per share”. This is the E in P/E. When looking at P/E ratios, it is important to examine the earnings and make sure that they are all “real”. If the trailing twelve-month earnings are boosted by some goofy accounting trick in tax expenses or amortization/depreciation, then the P/E can be artificially low.

Usually, when you see quoted values for operating income and earnings per share, it is referred to as “TTM” or “trailing twelve months.” This simply means that they are adding up the numbers over the last four quarters to show you a trailing year of earnings and income.

Most investors use “forward” P/E ratios, or a P/E based on estimated future earnings. Forward earnings estimates are relatively worthless. The backtesting proves this. There is no value ratio that tests as bad as forward P/E’s.

Cash Flows

The statement of cash flows summarizes the change in a company’s cash position from one period to another. The total change in cash on the statement should tie into the change in “cash and equivalents” from one quarter to another on the balance sheet.

The statement of cash flows wasn’t required until the 1970s, after many company blow-ups that weren’t detected on the income statement. If a company is generating tons of sales and income, but they’re burning cash, it’s going to be difficult for them to stay in business over the long-run.

Warren Buffett contends that the real value of a company is the cash flow it can generate for the owner over time.

The statement of cash flows is broken down into three sections:

Cash flows from operating activities – This is the section that focuses on the cash that is actually being generated from the business. This is the section that most value investors hone in on. It begins with net income and subtracts all non-cash expenses like depreciation and amortization (because they aren’t real cash expenses). Ideally, the number should be positive, demonstrating that the company is actually generating cash for its owners.

Cash flows from investing activities – This shows you how much cash the company generated from its investing activities. If you were to go out and buy a stock or a bond, it would be a negative number on the statement. If you sold stock, it would be a positive number on the statement. It doesn’t show if the asset was sold for a profit. It simply shows how much cash your investing activities generated. A negative number here isn’t necessarily a bad thing. It simply means that the company bought financial assets more than it sold them. A positive number isn’t necessarily a good thing because it doesn’t tell you if the company sold the asset for a profit.

Cash flow from financing activities – This is cash flow related to the activities of the company outside of normal operations and investing activities.

Cash that the company paid out in dividends to the owners or used to purchase back stock would be a negative number for this. Money borrowed from a bank would be a positive number because that’s cash coming into the company.

The net effect of all three sections will show you the net change in a company’s cash position in a quarter or a year. This change should tie into the “cash and equivalents” section that is on the balance sheet.

High positive cash flows are not necessarily a good thing. If the company is bringing in cash through debt issuance or issuing new shares (diluting your ownership stake), it is not good for investors.

A term that value investors use frequently is free cash flow. This is what you want to focus on when examining the statement of cash flows. Warren Buffet refers to this as “owner’s earnings.” Free cash flow is simply: Cash Flows From Operating Activities – Capital Expenditures. You can find the capital expenditures as a line item in “cash flows from investing activities”. For the above example, they list it as “purchases of property, plant and equipment”. In other words, free cash flow excludes all of the other investing and financing activities conducting by the company.

Free cash flow focuses solely on cash generated by the operating business minus the money spent to keep the business operating.

If you were to buy the business in its entirety, free cash flow is the money that you would have as the owner to (1) pay yourself in the form of dividends or share buybacks, (2) invest to generate more cash flow in the long-run. Free cash flow is the cash available to you, the owner of the business.

Summary

I hope you find this brief summary useful. I know I could have definitely used this breakdown years ago when I got started investing in individual companies. It’s not as hard or intimidating as it appears on the surface.

Investors frequently lose sight of what a share of stock is. A stock isn’t a ticker symbol and a number. It’s not a line on a chart that bounces around that you can find hidden meaning in. A share of stock is an ownership interest in a company. You are a part owner of a company. Before you lay down a dime, you should find out what that company does and understand its financial position.

If this homework sounds too hard, then you shouldn’t go out and buy stocks in individual companies. If you are willing to put in the work, then give it a shot.

There is obviously much more to learn about financial statements and company research, but I hope this is an excellent basic summary that you can use as a springboard to learn more.

Accounting is boring, but it is the language of business, and it’s essential that you know it before you go out and buy an individual company’s stock.

“You Can be a Stock Market Genius” is Joel Greenblatt’s classic 1997 book. Don’t be dissuaded by the ridiculous title. This is a money making handbook for the small investor who is willing to get their hands dirty and do a lot of homework.

Joel Greenblatt is one of the best investors of all time. I reviewed another book of his: The Big Secret for the Small Investor in this blog post.

The two books have the same philosophical value investing orientation but are polar opposites in terms of difficulty. The Big Secret is for passive buy-and-hold investors who don’t want to deal with all of the homework of actively picking stocks. You Can Be a Stock Market Genius is a homework-intensive strategy that Joel employed when he was running his hedge fund from 1985-1995 and achieved 50% annual returns.

No passive strategy will get you 50% returns. No systematic quantitative approach will get you 50% returns. Achieving that kind of stellar performance requires a hell of a lot of work and luck. The book is Joel’s outline of the various hunting grounds that he used to generate those amazing returns.

The Small Investor’s Advantages

The book opens with an inspiring message. The small investor has advantages over prominent professionals. Big professionals managing billions of dollars in capital can’t: (1) concentrate in a handful of small positions, (2) take the career risk of dramatically underperforming the benchmark (they’ll get fired), (3) won’t invest the time and resources necessary to investigate weird and tiny situations that they can’t allocate a significant portion of their capital to.

A small investor can do all of those things.

In a world where ETFs with 50 positions are considered “concentrated”, Joel’s definition of “concentrated” is wildly different than the mainstream view. The mainstream view is that “risk” is volatility of returns and “risk” can be reduced by holding more positions. Joel suggests that as few as 8 stocks in different industries is sufficient to properly diversify a portfolio.

8 stocks would result in so much volatility that it would be career suicide for any professional investor. Most people can’t handle volatility. A small investor with the right temperament can. Unfortunately, most small investors squander this advantage. We’re never going to beat Wall Street at their own game: namely, smoothing out returns and reducing volatility (i.e., pain) with fancy financial engineering.

What we should do is focus on the advantages that we have: (1) Temperament – If we have the proper temperament to endure volatility, we can achieve better results. (2) Size – If we’re willing to focus on areas that are hated and ignored, roll up our sleeves and do the work, we can concentrate in situations that Wall Street pros can’t.

I did some backtesting of my own a few months ago to test the limits of concentration. I looked in a Russell 3000 universe with a straightforward strategy of buying the cheapest stocks on an EV/EBIT basis. I constructed portfolios rebalanced annually beginning with 1 stock (the cheapest in the universe) and then just adding the next cheapest. I then plotted the monthly standard deviation of returns (Wall Street’s definition of risk – which is a flawed concept, but whatever).

It looks like Joel Greenblatt is correct. Most of the volatility is meaningfully reduced with a handful of positions. He offers a caveat, however, and suggests that if you are going to run a concentrated portfolio, it is best to diversify among a group of different industries. In today’s market, for instance, it may be tempting for a value-driven bottom feeder like myself to own 10 retail stocks. This would be a bad idea.

Wall Street pros and most investors have no stomach for volatility. We saw a vivid example of this in February. The market fell 10%. This is a remarkably normal event in the grand scheme of things. I was on vacation at the time that this happened and couldn’t help but laugh at the insane overreaction to this little event. It generated headlines like this: “Stocks Plunge and Traders Panic” – The Wall Street Journal, “Dow falls more than 1,000 in biggest daily point-drop ever” – thehill.com

If you want to achieve better than average results, you need a better than average temperament to ignore this nonsense.

How to think about the market

Joel tells two stories in the book that represent excellent ways to think about the stock market.

The first is a story about his in-laws. His in-laws were amateur art collectors. They weren’t looking for the next Rembrandt or Picasso, they were looking for small-scale mispriced works of art. They went to yard sales and flea markets looking for paintings that were cheaper than their value. They would find paintings that were at the yard sale for $100 that they knew were worth $1,000, for instance.

This is a useful way for small investors to think about the stock market. The professionals need to find the next Rembrandt and Picasso. We should let them fall over themselves trying to figure out what company is going to be the next Facebook or Microsoft. Most of them will fail and a handful will be lauded as geniuses (they were probably just lucky). For us, we can achieve satisfactory results by merely finding things off the beaten path that is a decent discount against their intrinsic value.

Joel tells another great story where he went to the best restaurant in New York, Lutèce. Joel asked one of the chefs if an appetizer on the menu was good. The chef replied with: “it stinks.” The message was clear: it didn’t matter what you ordered off the menu. Everything was excellent because Joel was at the best restaurant in New York. The best way to invest in the stock market is to identify those places that are the best places to invest, where no matter what you pick, the chances are that it will be good.

The book outlines some key hunting grounds where Joel had success finding these opportunities.

Spin-Off’s

The goal of investing is to find mispriced assets. You want to seek out areas of the market where stocks are prone to mispricing.

One area that Joel finds to be replete with mispricings is spin-offs. Spin-offs are divisions or subsidiaries of a larger company. The larger company decides to “spin off” that piece into a separate company.

Why do companies do this? They may think that if they isolate the entity in the market, it will be able to command a higher valuation. For instance, let’s say (in an extreme example) that an insurance company owned a financial software division. Software companies have higher P/E ratios than insurance companies. However, the market might not appreciate the software company because it is buried in an insurance company. If they spun it off – the software company would probably command a higher valuation if it were isolated.

The larger firm might also want to separate itself from a “bad” business that is weighing it down. They might just want to use the spin-off to unload debt on a smaller firm. There could be tax or regulatory reasons. They might have difficulty selling the business, so they decide to dump it in the form of a spin-off.

Whatever the reason, spin-offs are prone to mispricing. This is because institutions and people often sell them for reasons other than the intrinsic value of the company. Some institutions might not even be allowed to own it due to small market capitalization, or it doesn’t fit into their “strategy.” Individual investors probably wanted to hold the larger business and have no interest in owning something completely different. In any case, spin-offs are prone to indiscriminate selling, which creates mispricings and opportunities for smaller investors like us.

In the book, Joel takes you through several real-world examples of spin-offs. He explains why the spin-off was pursued and why he thought it was an attractive opportunity to invest in.

Currently, I own one spin-off in my portfolio: Madison Square Garden Networks (MSGN). My rationale for holding it is described here. I became aware of the opportunity when looking at a list of recent spin-offs back in 2016.

Mergers

Joel then moves onto mergers as an opportunity for mispricings.

He first addresses the obvious: merger arbitrage. Merger arbitrage is buying a stock after a deal is announced and trying to earn a spread between the buyout price and the market price. For example, let’s say a company is trading at $30 and another company buys it out for $40. As soon as the deal is announced, the stock will rally to $39. A merger arbitrage strategy would buy the stock at $39 and wait for the deal to be consummated.

Joel thinks this is a dumb strategy and I agree with him. The reason is that you are taking on the risk of the deal not going through, in which case the stock will plummet. Mergers fall apart all the time, usually for regulatory reasons. Why take on that risk to make a measly 2.5% gain in the example I provided (in the real world, those spreads are even smaller and keep getting smaller as more people become involved in merger arbitrage).

It’s a strategy that might make sense for a big institution that can hire lawyers and analysts to know for sure whether a deal will indeed go through, but that’s not something small investors like myself can take advantage of.

Where Joel does believe there are opportunities for investors is in the world of merger securities. Often, a buyout can’t be financed entirely with cash and debt. Sometimes, strange derivative securities are sold (usually warrants) to fund a piece of the transaction. Investors will often indiscriminately unload these merger securities, and this will create mispricings.

The difference between a warrant and an option is that a warrant is issued by the company. That’s it. Both of them are merely a contract to buy or sell a stock at a pre-determined price on a future date.

Joel thinks this is a good area of opportunity. I don’t disagree, but I think that pricing merger securities are beyond the abilities of most small investors like myself. I’ve never owned an option or warrant in my life and place it in my “too hard” pile. You might want to tackle it and more power to you.

Like the spin-off section, Joel takes you through a few real-world examples of times that he purchased merger securities and did very well. I think the strategy is too hard to implement for the small investor, but you might disagree.

Joel does not recommend buying stock in bankrupt companies (that’s in the “too hard” pile”). The reason is apparent: equity holders can get wiped out in a bankruptcy. He does believe that the debt of bankrupt companies is often mispriced and offers incredible mispricings. Unfortunately, distressed debt investing is not only challenging to research for small investors but frequently impossible for anyone but an institution to invest in.

He believes that small investors can invest in companies emerging from bankruptcy or going through a restructuring. Often, a company went bankrupt only because it was loaded up with too much debt. They might have a viable business model that was merely being weighed down by too much debt. After emerging from bankruptcy or going through a healthy restructure, it may give the company an opportunity to shine. Meanwhile, the stigma of the bankruptcy creates a nice discount from intrinsic value.

Options

Most classic value investors (me included) think that options are an area that is best for most people to avoid. I agree with this sentiment. Options (and warrants, which are the same thing) are a zero-sum game. Only one side of the trade wins: either the person who wrote the contract will win, or the person who bought the contract will win. They can’t both make money. Zero-sum games are usually areas of the market that are difficult for small investors to make money.

Joel takes a bit more of a liberal attitude towards options. While he doesn’t recommend actively trading options, he does suggest using long-term options (LEAPs – options contracts that mature in over a year) as a way to leverage up the return on a value stock. A LEAP will experience much more significant price swings than the overall stock. If a reasonably priced value stock experiences a 20% gain, for instance, the underlying LEAPs contract will experience a much more significant increase. It’s a way of leveraging up the bet, with the caveat that if the stock falls below the strike price, it will expire worthless. More risk, more reward.

Joel does not recommend that these bets comprise a significant portion of a portfolio, but argues that they can serve a place to amplify returns.

For me, I put all of this in my “too hard” pile. When I contemplate buying options or warrants, it sounds to me like someone saying “Let’s try crack. What could go wrong?”

Conclusions

You should read this book! My brief summary doesn’t do the book justice. While I gave you the broad strokes in this blog post, there is nothing like reading the book and going through the case studies which Joel provides. He provides you with his entire process: how he found out about a specific opportunity, what he liked about, where he researched it and how the idea worked out.

The first and last chapters are useful for developing a template for thinking about markets. As I stated earlier, the goal is to find mispricings. That often means going off the beaten path and finding forgotten and hated corners of the market. Joel provides a roadmap to a few areas that served him well, but they are by no means the only ways to do it.